Wednesday, March 13, 2013

Is It Time for the Three-Tier System to Go?

Most people don't realize how different the beverage alcohol business is from other consumer products businesses. The fact that beverage alcohol products carry a much higher tax burden is just the beginning.

The 21st Amendment to the Constitution, which ended Prohibition in 1933, is short and sweet. The second section is the important one. It gives states the right to control "the transportation or importation" of alcohol within their states. States do not similarly have the right to control "the transportation or importation" of Coca-Cola or Twinkies, as in most cases the Constitution's Commerce Clause assures a nationally-regulated market.

One of the ways states control alcohol is through the three-tier distribution system. The tiers are producers, distributors, and retailers. Other businesses have similar channels of distribution but with alcohol, it's not optional. The essence of the system is that producers (i.e., distilleries, bottlers, importers) cannot sell directly to retailers (i.e., bars and stores). They must sell to an intermeidary, the distributor, and all retailers must buy from that intermediary. Furthermore, a producer can't have an interest in a distributor or retailer and distributors and retailers are similarly restricted.

One exception to the no-cross-ownership rule is for the state itself, which can be both distributor and retailer. There is no state in which the state operates bars but several operate all of the state's liquor stores.

The other exception to the no-cross-ownership rule is distillery gift shops. In that case, the producer can own a retailer, but the gift shop still has to buy the merchandise from a distributor. It does not, however, have to be shipped from the distillery to the distributor's warehouse then back to the distillery for sale. The transaction is all on paper, but it's still absurd.

Since each state can set its regulatory scheme up however it wants, each one does and they are all different. Each state makes producers jump through a different set of hoops.

The producers wish they could sell directly to major chains, and even directly to consumers through their own retail stores. Big retailers wish they could move their alcoholic beverage merchandise across state lines as easily as they do everything else. Producers can talk to retailers and they do, to set up promotions and such, but every deal has to go through a distributor, state by state.

The purpose of these systems was to prevent the perceived abuses that led to Prohibition in the first place and in order to get back in business, alcoholic beverage producers were willing to agree to just about anything. The system has changed little since it was established 80 years ago.

Today, the system has broken down in the sense that rules against cross-ownership are easily gotten around, and the local companies distributors were supposed to be are now legal fictions, since most distribution is done by national or large regional companies. The idea was that a producer could be remote and hard to touch legally, but a distributor would be local and thus more readily brought before the law. It's still true in the sense that distributors are required to have in-market assets, and operate through state-by-state subsidiaries, but for the most part they are massive and remote, larger than all but the biggest producers.

Today, the mandatory distribution tier merely adds cost without providing any benefit to anyone except the distributors themselves and their political patrons, including the state's Alcoholic Beverage Control agency (ABC), which itself is an anacronistic boondoggle.

Like a lot of Prohibition vestiges, the problems these systems were meant to solve don't seem like problems anymore, but the system doesn't change because there are people who have a powerful financial interest in keeping things the same. It's the kind of government waste that always seems to have bipartisan support.

How awesome would it be to walk into a store operated by a disstillery? You'd probably get actual MSRP on all products, plus product knowledge from the staff, plus info on limited edition products like, can I get one? that would be truly awesome.

While I certainly have issues with the three-tier system, but I don't agree that distributors "...merely adds cost without providing benefit..." Distributors stock inventory in the marketplace, provide a timely delivery service, and field a team of salespeople...all ensuring that a producer's products are relatively accessible to those establishments desirous of selling them.

For a producer to ensure a similar scenario exists in each and every market they do business in would be both time and resource consuming.

I'm all for dismantling/privatizing state-run ABCs, but there is NO WAY a producer can ensure adequate coverage in multiple markets without a distributor. Are they perfect? Hardly. But they are a necessity.

Thanks for putting this to print Chuck. I am one who firmly believes my state's (OK) alcohol laws are antiquated and in dire need of reform. We have a fourth layer here called the broker. They do nothing except shuffle paper and take their cut.

Recently a commission was formed to look into the situation and disbanded prior to completeing its research claiming too much would have to change to allow grocers to carry wine and spirits. Insiders claim the commission was a "planned failure" due to this state's aversion to change. Whatever the case, I hope more open and honest discussion will ensue and real progress can be made in alcohol law reform.

In 2011 initiate 1183 passed here in Washington State. Its main function was to privatize liquor sales, but it also allows retailers to purchase directly from any distillery in the country. Ironically, we've seen very little, if any, of this actually occurring outside of the small or local distilleries. The common sentiment seems to be "we're not going to break our bond with our distributor in XX states so we can sell a few percent of our product direct to retailers at a higher margin."

Whoa. Let's not get so excited about dismantling the publicly-run systems. I live in Montgomery County MD and our county is the distributor and runs the liquor stores.

Because they are a public entity they must publish EVERYTHING - the sheets they get from the distilleries included. We know the cost of the bottle of liquor from distillery to shelf.

And our prices are way lower than anything I have seen in any private system. Washington DC is just down the street, and they have a private liquor store system with higher prices. Howard County, just up the street, also private - higher prices.

The only problem is the occasional waiting list, but even that is transparent - you get on the list, you know what rare bottle you are in line for, and when it is your turn, you get a bottle. My last bottle of Pappy 15 I bought from MoCo for $38.

Not to say MoCo stores don't make a profit - they do. But they then turn it over to the county to pay for firefighters, cops and teachers.

Great points, Chuck. Agree that the role of distributor does add value, but it would be more competitive in a completely open system (including competing against the producers AND retailers). I'm pretty sure that some of the large chains (such as Costco) have their own distribution network which they could leverage - and that should give them a competitive advantage on pricing.

It would also be great for the alcohol industry as a whole. The state by state rules make it very challenging for a start-up or craft distiller to get access to markets. It also prevents the constituents of those markets from getting access to more product. My old man lives in Michigan, and it can be frustrating to know there are some incredibly interesting things going on which he can't partake in due to this outdated structure.

As you point out - the distributors and gov agencies are the big proponents, but who would benefit the most from lobbying to change? I would think both the producers and retailers would win in that model (not to mention consumers!) It sounds like those groups who would win need some support to take on that challenge.

Any efficient means to warehouse/sell/deliver/invoice would still look a lot like what's in place right now. A supplier who thinks that direct sale in all 50 states is the way to go either doesn't understand the logistical complexities involved, or has way too much free time on their hands.

Again, I'm no big fan of the existing model (especially State-run ABCs), but - having considered alternatives - can't imagine one that would be a vast improvement (from cost, logistical, efficiencies, etc.) than what's in place.

Chuck, let's say we did away with distributors. What type of system would you envision/suggest?

Simple. Distribute booze the same way you distribute Twinkies or Tide. Costco, Walmart, and Chili's will probably make national buys and self-distribute. Distributors will still exist to supply smaller retailers, just like with every other kind of consumer packaged good. "But alcohol is different," some will argue, but those differences can be accommodated by a free market system. End Socialized Booze!

I don't think anyone is saying "socialized booze" means better prices for consumers. If the process is inefficient due to arcane regulation, logic dictates that a more efficient process would cut costs. While that is not a guarantee that the savings are passed onto the consumer, market mechanics pretty much take care of that. If I own Store A and decide to hike up my prices, but Store B does no such thing . . . I'll see business go down pretty quick. Having the state fix prices just eliminates any incentive for anyone to innovate or improve the process.

I'm in complete agreement with you regarding the desire to change our convoluted liquor distribution laws. That said, of all the things in this country that are broken because of the strangle hold corporate money has on our politics this one ranks near the bottom in terms of importance.

I don't understand why distributors deserve such protections. But I REALLY don't understand why here in Texas, liquor stores deserve protection. If you have a mixed drinks license, you have to buy from a liquor store in your county. I happen to be in a county with ONE liquor store. So they have a monopoly that's protected by the state. Predictably, my prices are high, very high. Higher, in fact, than retail in most of the state. So much for competition, free markets, independence....

While your suggestion might sound 'simple', it ain't gonna happen. Too many regulations on alcohol (both legal and societal) for it not to remain a regulated consumer product which requires licensed wholesale distribution.

I'd for it in theory, except that, in the end, a system such as the one you propose has every likelihood of benefitting the large brands and large buyers, to the exclusion of the small producer. It would impose a burden such that they risk either being limited in future growth potential, or of going out of business altogether.

Richnimrod says;I'm the "Old Man" (referred to by 'Gary') that is stuck in Michigan's regressive, repressive, arcane liquor-control regulatory Hell. The main thing I'd anticipate if we could do away with the three-tier system, and the tight State controls will be the arrival in the 'Mitten State' of a lot more options in liquor (Bourbon) than are currently available here. The BIG producers are well represented; but the smaller ones, and certainly craft producers, are almost almost non-existent on our retail shelves. A price war on Bourbon would be lovely; but it's those additional choices I want.

Mat, your comment reminded me of when compact disks began to replace vinyl. There was much fretting that the 'little guy' would be frozen out because of the cost of CD technology. The exact opposite happened. The point is, when the ingenuity of the free market is unleashed, you never know.

While it is possible that in one instance, effecting an inestimably small number of people the 3 tier system has lowered prices, a system that was designed to make the Booze industry less efficient cannot be good. One aspect that no one has discussed is choice. In the wine trade, this "service" provided by distributors means that smaller winerys, offering smaller volume products are often frozen out of the market by big distributors who have little incentive to offer risky lines that might compete with big accounts. With the growth of micro-distilleries I believe this problem will become more acute in liquor sales.

I work in the cigar industry and I can tell you with 100% certainty it would be a much better system if a liquor store could buy product as I can. I am factory direct with all my manufactures. This ability allows me to price my cigars very competitively with out having to pay a cut to a distributor. There are distributors in this industry to supply guys who are not factory direct and it costs them more to buy the same product I can. They have two choices, charge more to make the same margins or sell at the same price I do and make a smaller margin. This type of system in place just adds cost to booze and prevents competition. I live in a control state and it sucks as far as selection. The state wont get things unless they are fast sellers. This leaves guys who are looking for small production stuff S.O.L. I can buy almost anything from the state but they require you to buy a case of it to get it. I don't know about you guys but do you want to buy a case of a whiskey you've never had with out trying it? I sure don't. I wish we'd get rid of the state controlled liquor stores here. I agree 100% with you Chuck.

Hey Chuck! Thanks for opening the dialog about this subject. Any time you have such a sweeping body of laws written so long ago and then continually patched for 80 years, it's going to be full of problems. There's way more wrong with the laws than distribution issues. Laws regarding public tastings and communicating about brands and who carries them, the so-called "inducement" laws, were not written for an internet or social media world. If you want to know just how screwed up ABC laws are, try to help a non-profit organization hold a fundraiser and see how much trouble you can get into.

While I firmly believe that the laws in California regarding direct sales at the place of production should be changed, I strongly disagree with the idea that the distributors bring nothing of value. Distributors maintain fleets of trucks, train and support teams of salespeople who educate on our behalf, and employ armies of bill collectors. As a supplier, I have no interest in doing any of that and value our distributors for the services they provide us and all the retailers we could never reach on our own.

Every tier is challenged and held back by archaic laws and stands to benefit from reform. An overhaul of the system is way overdue, but should be accomplished with all of the members of the three-tier system at the table as colleagues, not adversaries.

Yeah, I went around with them on that back in the fall. Those guys are good friends. The basic history is that it was a compromise for getting repeal of Prohibition ratified by the states, that each state gets its own little alcoholic beverage honey pot.